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Tuesday, July 1, 2008

Security Analysis: Chapter 1

Security Analysisby Ben Graham and David Dodd is a must read for anyone serious about value investing. Here follows a review of the first chapter.

The authors provide justification for the rest of the book. They are unimpressed with the "pseudo-analysis" that has taken place throughout the boom and bust of the late 20s and early 30s. They offer examples as to how investors of sound practice would have actually profited from market events of that time period.

They introduce the concept of intrinsic value, suggesting that each stock has an intrinsic value that is independent of its market price. Nevertheless, there are challenges with determining what the precise intrinsic value is, however, it can be estimated within certain ranges. Some companies will have wider ranges than others. Nevertheless, the idea is to find companies where the market price is below the bottom of this range, and the authors offer various examples of this having occurred in the market.

The authors go on to separate obstacles to successful analysis into three categories:

Inadequate or Incorrect Data

Uncertainties of the Future

Irrational Market Behaviour

A model suggesting the relationship between intrinsic value and market value is discussed, attempting to show how market prices are influenced by a variety of factors unrelated to intrinsic value (e.g. psychological factors).

Finally, arguments are made against "speculation" as opposed to investing. In speculation, there are far more elements of chance involved, which make it unclear whether success is the result of sound behaviour or the result of chance. Frequent trading also results in high fees...the odds are thus stacked in favour of the house, as it is on a roulette table.